Is rebalancing the source of factor premiums?

12-02-2015 | リサーチ

Some argue that the mere mechanism of rebalancing increases returns, and that this explains the success of factor investment strategies. Although factor strategies do need rebalancing to maintain their exposures, there are several reasons why it is unlikely that this is their source of added value.

David

Blitz

Head of Quant Research

Speed read

Factor investing requires rebalancing

Rebalancing is however not the source of factor premiums

It’s the other way around: factor premiums explain any positive returns from rebalancing

Factor investing requires rebalancing

Factor investment strategies are designed to harvest established factor premiums, such as the value, momentum or low-volatility premiums. One feature all factor investment strategies have in common is that they require periodic rebalancing, as the factor characteristics of stocks can change over time. For instance, a value strategy selects stocks that are cheap on valuation ratios such as P/E. As time goes by, however, some of these stocks may become expensive on these measures, at which point they will need to be replaced by fresh value stocks in order to maintain the factor profile of the strategy. Without rebalancing, the factor exposures of a factor investment strategy would gradually deteriorate, until no exposure at all would be left. So rebalancing is an essential aspect of factor investment strategies.

But could rebalancing even be the source of factor premiums?

The importance of rebalancing for factor investment strategies leads some to wonder whether this rebalancing mechanism could be the actual source of factor premiums. We argue, however, that this notion is incorrect, i.e. that rebalancing is not the source of factor premiums.

First of all, the outperformance of portfolios with attractive factor exposures is mirrored by a similar-sized underperformance of portfolios with unattractive factor exposures. If we consider for instance the value premium, studies find that the outperformance of cheap (e.g. low P/E) stocks is mirrored by a similar-sized underperformance of expensive (high P/E) stocks. Similar results are found for the momentum and low-volatility premiums. As both types of portfolios involve a similar amount of rebalancing, it is clear that factor exposures are driving their returns, and not the shared rebalancing mechanism.

‘Portfolios with unattractive factor exposures rebalance just as much as portfolios with attractive factor exposures – and still underperform’

Factors behave very differently, which argues against one underlying driver

In addition, different factors behave quite differently, have different explanations and are widely regarded as distinct phenomena. Value and momentum even have a negative correlation, as stocks with strong momentum tend to have become more expensive, while a large price decline tends to make stocks cheaper. In addition, value and momentum both have the tendency to select more risky stocks, thereby going directly against the low-volatility effect. This makes it quite unlikely that they are a manifestation of the same, shared underlying driver.

Many factor strategies do not even need much rebalancing to begin with

Another argument is that many factor investment strategies do not need much rebalancing to begin with. Consider for example the low-volatility factor. Clearly, low-volatility strategies based on very short-term volatility measures require quite some rebalancing, but as the estimation period for past volatility is lengthened, less and less rebalancing effort is needed. A portfolio based on past 10-year volatility hardly changes from month to month, and comes pretty close to a buy-and-hold strategy.

Investors interested in harvesting the value premium do not need to engage in a lot of rebalancing either. Chow et al (2011) show that a fundamental index, which is designed to capture the value premium, only requires an annual (one-way) turnover of about 15%, meaning that positions are held, on average, for almost 7 years. Given that many factor investment strategies require so little rebalancing, it is hard to argue that it is the rebalancing mechanism which is really driving their return.

‘If there is a causal relation it is more likely to be the other way around’

Rebalancing to get back to starting weights

Besides maintaining factor exposure, rebalancing can also be done with the mere intention to bring portfolio weights back to their original values. Theoretically the impact of this type of rebalancing on return can be positive, zero or negative. After all, rebalancing can be beneficial or harmful, depending on the circumstances. As the theoretical results are inconclusive, Hallerbach (2014) conducted various empirical tests, but again the results turn out to be mixed: the rebalancing return is sometimes found to be positive and sometimes found to be negative. We can therefore conclude that rebalancing is neither theoretically nor empirically a reliable source of return.

Turning the argument around

Rebalancing back to starting weights can induce implicit exposures to some of the classic factor premiums, as stocks which have become big, expensive or have done well are sold in favor of stocks that have become small, cheap or have done poorly. These factor exposures turn out to be able to explain most of the performance. In other words, there may indeed be a causal relation between rebalancing and factor premiums, but not in the sense that factor premiums are explained by rebalancing, but the other way around: positive returns from rebalancing may be attributed to implicitly induced exposures to classic factor premiums.

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